The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Fossil Group, Inc. (NASDAQ:FOSL) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Fossil Group's Debt?
The image below, which you can click on for greater detail, shows that Fossil Group had debt of US$225.3m at the end of June 2019, a reduction from US$396.1m over a year. However, its balance sheet shows it holds US$226.6m in cash, so it actually has US$1.30m net cash.
A Look At Fossil Group's Liabilities
Zooming in on the latest balance sheet data, we can see that Fossil Group had liabilities of US$527.6m due within 12 months and liabilities of US$541.0m due beyond that. On the other hand, it had cash of US$226.6m and US$204.2m worth of receivables due within a year. So it has liabilities totalling US$637.8m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$492.1m, we think shareholders really should watch Fossil Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Given that Fossil Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
Importantly, Fossil Group grew its EBIT by 33% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Fossil Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Fossil Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Fossil Group actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While Fossil Group does have more liabilities than liquid assets, it also has net cash of US$1.3m. And it impressed us with free cash flow of US$123m, being 164% of its EBIT. So we don't have any problem with Fossil Group's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Fossil Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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